Currency Armageddon

“Every gun that is made, every warship launched, every rocket fired, signifies in the final sense a theft from those who hunger and are not fed, those who are cold are not clothed.”

-Dwight D. Eisenhower

As I was preparing for my week long sojourn over to the United Kingdom, I actually had to think seriously about what type of currency I wanted to bring. After all, in this day and age of the modern currency war, the movement of currencies can be dramatic and shocking. If you don’t believe me, just ask those good folks that were long of Venezuela’s Bolivar going into Friday. In a split second, the government unilaterally devalued the Bolivar by 32% and likely put a few currency traders out of business.

In terms of global economies, according to the CIA Fact Book Venezuela is just the 34th largest economy in the world at just $400BN in annual economic output. Despite this, there were a number of multinational companies that were impacted by the devaluation. Specifically, Colgate-Palmolive and Smurfit Stone have taken charges, with comparable companies like Avon, Proctor and Gamble and Kimberly-Clark certainly at risk of a short term hit to both earnings and assets.

Obviously the popular pushback when we stress currency wars with U.S. focused equity managers is that they are a 3rd world type risk and not a concern or issue that will become broadly prevalent. In fact, this consensus view was verified to me as I opened the Irish Times this morning to an article titled, “Fears of an Imminent Currency War Are Wide Of the Mark.” Of course, many of these money managers have only been managing money for the last 10 – 15 years, so they may have missed this little critter called the Plaza Accord.

Now admittedly, the Plaza Accord was not a unilateral devaluation or war, but rather an agreement by Germany, Japan, France, the United States, and the United Kingdom. The agreement by these five nations was to intervene in global currency markets with an objective of devaluing the U.S. dollar in relation to the Japanese Yen and German Deutsche Mark.

Not surprisingly when the world’s largest central banks gang up to achieve a goal, they succeed, and the U.S. dollar depreciated dramatically over the next two years. In fact, the dollar depreciated versus the yen by almost 50% from 1985 to 1987. By some economists, this devaluation was heralded as a glorious success as the devaluation was controlled and did not lead to a financial panic.

While the last point is true, the strengthening of the Japanese yen was likely a key catalyst for one of the most significant bubbles of the last three decades, if not hundred years – the Japanese real estate bubble. Naturally, given that the U.S. dollar was set to decline, the Japanese that had their assets abroad repatriated and began purchasing Japanese real estate, and purchased more, and purchased more. In fact, at one point choice properties in Tokyo’s Ginza district were trading hands at $20,000 per square foot.

For Japan, the acquiescence to the United States to devalue the U.S. dollar led to an asset bubble of incomparable proportions and then an effective lost decade(s) of economic activity (and then some) as the Japanese economic system de-levered. My point in highlighting this is simply that devaluations, like much of government intervention in the markets, has unintended consequences. In hindsight, the Japanese likely never would have signed up for the Plaza Accord had they understood the unintended consequences. In part, this experience is likely shaping their new policy of going at their currency strategy alone, rather than suffering the beggar thy neighbor option of a Plaza Accord type agreement.

There is obviously a worst case scenario as it relates to currency wars, that scenario in which all nations devalue at once. Not unlike during the Cold War, when both the Soviets and Americans were armed to the hilt with nuclear weapons, this global devaluation is also likely a race to MAD (Mutually Assured Destruction). For lack of a better term, we’ll call it Currency Armageddon.

The broad implications of a massive global currency war actually relate back to the quote from Dwight Eisenhower at the start of this note. In a normal war, goods are taken from the people to create weaponry. As a result, the average person is worse off during a war. On some level, a currency war is no different.

As currencies are devalued, the purchasing power of the average citizen is degraded and as a result so is their ability to purchase basic goods. If you don’t believe me, ask the average citizen of Venezuela whose purchasing power was decimated by this move on Friday. This quote from a recent Bloomberg article about a rush to buy airline tickets was particularly apropos:

“I came because I heard American Airlines is going to raise fares by 100 percent, that’s to say, above the devaluation.”

Interestingly, there is an alternative to Currency Armageddon and its unintended consequences. This is the exchange rate system implemented post World War II called the Bretton Woods system. In this period of semi-fixed exchange rates, competitive devaluation was not an option. Not surprisingly, under Bretton Woods global economic activity thrived and was stable.

This is not to say that Bretton Woods was an ideal system, but what seems less than ideal is the ability of major governments to unilaterally devalue on a whim, which is the nature of the monetary system today. The most recent example of this is of course Japan and the rampant devaluation of the yen. This will last until the average retiree in Japan starts to feel the fiat currency squeeze like the Venezuelans have. Interestingly, Japan is almost half way there with a Yen that is down over -15% in only three months.

Now, on one hand, shorting the yen was an existing idea we re-presented on our Best Ideas call on November 15th and that trade is up ~14% since then, so we are happy about that. But as we contemplate risk managing future economic shocks, the idea of Currency Armageddon is a risk that every day seems less and less like a tail risk and more like a 2013 type event, despite what we might be reading in the Irish newspapers.

Go With What Is

This note was originally published
at 8am on January 29, 2013 for Hedgeye subscribers.

“The world is not the way they tell you it is.”

-George Goodman

That’s easily one of the top opening sentences to any book in my library (The Money Game, by George Goodman). And oh how true does it ring about the game so far in 2013.

You see, so far 2013 is all about you. “You – your identity, anxiety, and money” – that’s what Goodman (under the pseudonym of “Adam Smith”) titled Part I of Chapter 1 in 1968. So what I am about to write this morning is not new. It’s just put another way.

“The successful investors I know do not hold to the way it ought to be, they simply go with what is.” (page 19)

Back to the Global Macro Grind…

Now maybe people write these sorts of things at all-time highs in markets (the Russell2000 made another all-time closing high yesterday at 906 = +6.7% YTD). Maybe they write them at the lows too. I’d just as soon as think about them all of the time.

One way to contextualize behavior is by using math across multiple-factors and durations. Internally (and at hedge funds I have built and traded portfolios for), we call them STYLE FACTORS.

If you punch in style factors on either Amazon or Wikipedia, you’ll get a promo for the “Otterbox Commuter Series Hybrid Case” (iPhone4) or something about the “Seven Factors of Enlightenment” (Buddhism). So, while I think most quantitatively oriented risk management platforms consider these factors standard, they are far from Jeremy Siegel’s view of portfolio theory.

Style Factors are what are moving your portfolio now – here are some big ones that are outperforming YTD:

High Short Interest = +6.8% (outperforming low-short interest stocks by almost 1%)

High Beta = +8.1% (outperforming low-beta by over 4%)

High Debt/EV = +7.0% (outperforming low-debt/EV by 60bps)

I can also slice and dice your portfolio across geographic, sector, and size (market cap) factors. And I do for our clients who ask us for this custom advisory and risk management work, but for your general reading purposes this morning I guess the bottom line is to take my word for it – it works.

Why does it work? Particularly when you overlay it with a multi-duration (TRADE/TREND/TAIL) price/volume/volatility model, it basically tells you what the machines are chasing. If you can front-run the machines, you are one step ahead of your competition. And that may not sound like what we all learned at school, but it’s the way that today’s game is.

If you own something like Netflix (NFLX):

You are long High Short Interest

You are long High Beta

You are smiling

Combined with a little storytelling from the management team and a catalyst on top (the recent quarter and conference call), that makes for a tasty YTD return. It also drives the fundamentalist who thinks the stock is “expensive” right nuts.

“If thinking of this fascinating, complex, n-person process as a Game helps, then perhaps that is the way we should think. It helps rid us of the compulsions of theology.” (George Goodman)

In other words, don’t play the game you want – play the game that’s in front of you. Modern day math, machines, and real-time signals help augment your go-to-moves. They also help you realize when it’s a good time to just get out of the way.

Yesterday was the 1st down day in the SP500 in the last 8 trading days. Within minutes of the market going down, my contra-stream (I built it on Twitter for my own behavioral observation) lit up like we were about to see the apocalypse. *Note: we didn’t.

I’m as leery about buying high as anyone, but through making many mistakes I’ve taught myself to use the risk of the range (within the context of all aforementioned factors) as my guide instead of my gut.

For the SP500 itself, here are some important Risk Ranges to contextualize and consider:

S&P Sector Studies = all 9 are bullish TRADE and TREND for the 17th day out of the last 18!

US Equity Volatility (VIX) = Bearish Formation with a Risk Range of 12.04-14.36

In other words, go with what is, until it isn’t. The high-probability hand you keep playing is that US stocks make higher-highs as equity volatility makes lower-lows. If and when that changes (it will, and maybe abruptly), Mr. Market will let you know.

BKW DOWNSIDE REMAINS

Burger King is reporting 4Q12 earnings on Friday. We believe that this release will add credence to our thesis that the company was never “fixed” during its stint as a private company, as the bulls are claiming.

The performance of the U.S. & Canada store base (60% of total) continues to carry the most weight for the BKW investment thesis. The outlook in this division, for Burger King, is not positive from a comparable sales growth perspective.

We estimate that 4Q12 comparable sales growth was roughly 2% versus consensus of 3.4%. January comparable sales among some North America franchisees are tracking as low as -4%, versus consensus for 1Q franchisee comps of +1.6%.

1H13 is when the company will have to prove the sustainability of its sales growth and, if early indications are correct, some concern may be warranted on that front. We believe the shares could trade below $13 over the intermediate-term, based on the cash flow multiple contracting by two points. As the chart below illustrates, consensus is very bullish on 1Q13 comps. The Street is assuming a 230 basis point sequential acceleration in 1Q13 two-year average trends.

Howard Penney

Managing Director

Rory Green

Senior Analyst

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